The residual distribution policy approach to dividend policy is based on the theory that a firm's optimal dividend distribution policy is a function of the firm's target capital structure, the investment opportunities available to the firm, and the availability and cost of external capital. The firm makes distributions based on the residual earnings.

10. The residual dividend model Aa Aa The residual distribution policy approach to dividend policy is based on the theory that a firm's optimal dividend distribution policy is a function of the firm's target capital structure, the investment opportunities available to the firm, and the availability and cost of external capital. The firm makes distributions based on the residual earnings Consider the case of Purple Hedgehog Forestry Company: Purple Hedgehog Forestry Company is expected to generate $240,000,000 in net income over the next year. Purple Hedgehog Forestry's stockholders expect it to maintain its long-run dividend payout ratio of 30% of earnings 40% Equity 60% Debt If the firm wants to maintain its current capital structure of 60% debt and 40% equity, the maximum capital budget it can support with this year's expected net income is If Purple Hedgehog Forestry increases its debt ratio, then its dividend payout ratio will all other factors are held constant. , assuming that Most firms have earnings that vary considerably from year to year and do not grow at a reliably constant pace Furthermore, their required investment may change often. Does this mean that the residual distribution policy approach can't be of any help to most firms? No Yes Gaven Industries, which is in the same sector as Purple Hedgehog Forestry, exhibits very stable and predictable earnings, but its capital investments tend to be lumpy. This means that Gaven's required capital investment spending is usually relatively low, but every few years, some sizable expenditures will cause the firm's capital budget to be quite large. Should Gaven Industries be following a strict residual distribution policy? No Yes